Saturday, 4 October 2008

Avoiding the Temptation of Beaten-Down Stocks

The managers of First Eagle Overseas -- a fund that's never had a losing year -- aren't finding cheap shares of battered financial companies appealing.By Stacy RapaconOctober 2, 2008

In troubled times, bargain hunters typically feast on a buffet of beaten-down stocks. But the managers of the First Eagle Overseas (symbol SGOVX) are not yet tempted by many new opportunities. Instead, they're mostly nibbling at familiar flavors and adding to existing positions.

With his cautious investing style, manager Jean-Marie Eveillard is a renowned worrywart who, time and again, has steered Overseas to positive returns through all sorts of markets. Since the fund's inception in 1993, it has closed every calendar year in the black.

Although Overseas tends to lag in rapidly rising markets, it has usually fared well during trying times. During the 2000-02 bear market, it gained 9% while the MSCI EAFE index, which tracks the stocks of developed foreign markets, lost 47%. And although the fund has lost 15% this year through October 1, it beat the index by 13 percentage points and ranks in the top ten of all international stock funds.

Eveillard, who also co-manages three other funds, plans to retire, for the second time, next March. He originally stepped down in 2004 but returned in 2007 after his protégé and replacement, Charles de Vaulx, suddenly left. Newly appointed co-managers Abhay Deshpande, who joined First Eagle in 2000, and Matt McLennan, who recently came from Goldman Sachs, will be left to fill Eveillard's shoes, assisted by ten to 12 analysts. Eveillard will remain with the fund as an adviser. "All of us live and breathe Jean-Marie's investment style, and that's why we're all here," says Deshpande.

That style is to "look for bombed-out industries or countries and try to sift through the rubble," says Deshpande. Often, the team finds potential candidates by talking with management, customers and competitors of companies whose shares the fund already holds. The managers like stocks that are priced cheaply based on assets and cash flow. And they're interested in a business only if it sells for 30% to 50% less than what they think it's worth.

You'd think that because stock markets everywhere are crumbling, plenty of opportunities would materialize. But Deshpande says there's little new to attract the mangers. "Most of the destruction we've seen around the world has been in industries that we don't really care for too much -- financials, retailers, that kind of stuff," he says. "I'd be more excited if the price declines were greater in the nonfinancial, nonleveraged names."

Still, the managers are putting money to work. In the past couple of months, Deshpande says, the fund's cash holdings went from 14% to 12% (which leaves it with plenty of purchasing power). "Certainly right now, we're net buyers," he says. "We do find some opportunities here and there."

One company the team found in the past year is Nissay Dowa. Eveillard says the Japanese property-and-casualty insurer is solid on both sides of its business: The underwriting side is "slightly profitable, year after year" and the investment side is "vastly overcapitalized."

The company also holds a large portfolio of Japanese stocks that the First Eagle managers consider undervalued. They believe the stocks are cheap, in general, because the Japanese stock market began declining earlier than European and U.S. markets did, and it dropped further. "So, through Nissay Dowa, we get a double discount," says Deshpande. "We get the stocks at a discount, and the stocks themselves are cheap." And, says Eveillard, "There is nothing that a value investor likes better than a double discount." Nissay's shares, say Eveillard and Deshpande, sell at a 40% discount to the company's adjusted book value (assets minus liabilities, adjusted to reflect their fair market value).

Lately, the managers have been adding to their holdings in Italy-based Italcementi, the world's fifth-largest cement producer. First Eagle first purchased the stock in 2002 when "the cement industry in general had been crushed because of recessions in Europe and the U.S. in 2001," says Deshpande, who was an analyst for the fund at the time. Since then, the company has "created a tremendous amount of value through some mergers and acquisitions and just operating the business well," he says.

A good chunk of the portfolio is in gold-related investments. In all of his funds, Eveillard says, "We have owned gold for a while as insurance against extreme outcomes." At last report, Overseas held 7% in gold bullion and 3% in gold-mining companies.

One such company is Gold Fields (GFI), a South African firm whose American depositary shares trade in the U.S. The managers believe the company is worth $20 a share, based on its 1 million ounces of identified gold reserves. The stock closed at $7.73 on October 2.

First Eagle's Class A shares charge a 5% front-end sales commission and 1.12% in annual expenses. It requires a minimum $2,500 initial investment.

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